CEU Electronic Theses and Dissertations, 2017
| Author | Farkas, Miklós |
|---|---|
| Title | Three Essays in Financial Economics |
| Summary | My thesis contributes to understanding how innovative financial assets affect the behavior of financial market participants. The first two chapters focus on why credit rating agencies failed to correctly assess the riskiness of innovative structured products, like those of collateralized debt obligations. The third chapter investigates how the introduction of retail structured products may lead to systematic patterns in aggregate retail investor behavior. The subprime crisis began to unfold when markets realized that structured products designed to be safe are, in fact, toxic. Credit rating agencies prolonged this misperception by granting triple-A credit ratings to many of these assets. In an applied game theoretic setting, I derive the conditions in Chapter 1 under which credit rating agencies operating in a duopoly, similarly to S&P and Moody's, are likely to provide overly optimistic assessments of risk. The main innovation of Chapter 1 is that I allow agencies to learn about each other's assessments during the rating process. Importantly, learning enables agencies to cater credit ratings, that is, offer a higher rating to a given issuer based on the other agency's more favorable assessment. Catering is harmful for social welfare as it reduces the informativeness of ratings. I show that the negative welfare implications of catering are most severe when the skewness of the rated assets' payoff is large, similarly to the payoffs of collateralized debt obligations. Chapter 2 builds on the framework of Chapter 1 and investigates how a rating agency calibrates its information technology as a response to changes in its business environment and also whether it has sufficient incentives to invest into information acquisition. I show that the agency's business environment has a strong effect on calibration and, in turn, on rating standards. Additionally, while the agency's ability to calibrate may have the benefit of alleviating conflicts of interests in the industry, when these conflicts are extreme, the agency chooses to ignore additional information about rated assets' quality. This helps to reconcile the empirical evidence documented in the literature on structured ratings, according to which agencies ignored valuable information that was available to them at the time they issued their ratings. The third chapter is joint work with Kata Váradi and it focuses on retail structured products that are derivatives designed by banks for individual investors. Retail structured products became increasingly popular in the last decade as they enabled individual investors to trade with complex assets, that were previously not available to them. We analyze both empirically and theoretically a subset of these products, called knock-out warrants. Individuals can trade with knock-out warrants through stock exchanges and they allow individuals to place leveraged speculative bets in the market of their chosen underlying, like a stock index or a commodity. We show theoretically that in these markets individuals, on average, are likely to bet on price reversals, even if at the individual level investors randomly choose the direction of their respective bet. Using proprietary data from a bank, we provide supportive evidence for our prediction. We speculate that the setup of these markets may be beneficial for the banks if they need to hedge their own exposure to the underlying asset. The results of my thesis suggest that the presence of innovative financial assets often affect the behavior of market participants. In particular, assets with highly skewed payoffs may change market outcomes in unforeseen ways. The skewed payoffs of collateralized debt obligations seem to have an adverse effect on rating agencies' incentives to exercise due diligence. On the other hand, the skewed payoffs of knock-out warrants results in unintentional but predictable aggregate behavior of individual investors. |
| Supervisor | Kondor, Peter; Zawadowski, Adam |
| Department | Economics PhD |
| Full text | https://www.etd.ceu.edu/2017/farkas_miklos.pdf |
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